2016 – Recession fears gave way to hope

Macro Highlights
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20/01/2017

2016 was marked in turn by the spectre of recession, political risk and then hopes of “reflation”.

Under our analysis of economic events of 2016, three defining phases took place: the risk of recession, the return of political risk and improving GDP growth and inflation prospects. The central banks played an active role during each of these phases, as we expected, and the prospect of fiscal stimulus around the world helped rebuild confidence.

Risk of recession

2016 got off to a rocky start, as fears surrounding GDP growth in China made a comeback and triggered an economic backlash. Massive capital outflows from emerging markets weakened their currencies, while downward revisions to GDP growth forecasts and the strengthening dollar helped push oil prices downward. Emerging-market countries that produce oil and/or hold dollar-denominated debt were further weakened, and this led to additional capital flight. Fears sparked by the risk of recession gradually spread to developed countries, including the United States.

With investor confidence waning, the central banks made clear that they would adjust their monetary policy if necessary to keep the financial markets stable. Yet these announcements did not have the intended effect. Risk aversion even rose sharply after the Bank of Japan announced its negative interest-rate policy. For a time, the central banks were unable to restore confidence, as investors had serious doubts as to how much more monetary policies could actually do. Since massive quantitative easing programmes had already been put in place in a number of countries, investors feared that the only tool left to central banks was negative interest rates, which could lead to a currency war. Central banks had to change their message in order to reduce asset volatility. They made it known that they would not engage in a unilateral policy of competitive devaluation and that they had other tools at hand besides negative interest rates. The European Central Bank (ECB) in turn announced that it would increase its asset purchase programme from EUR 60 to 80 billion per month and expand it to include corporate debt.

Return of political risk

Another shock – this time political – took place on 24 June when the United Kingdom voted to leave the European Union. This triggered a rise in risk aversion and a quest for defensive assets. Once again, the central banks took decisive action. Most of them announced their readiness to deliver enough liquidity to keep the markets functioning, and this reduced systemic risk. Since the UK vote underscored growing doubts about the global economic outlook, the central banks also began communicating in more dovish tones, leading investors to expect more extensive and long-lasting monetary easing. As a result, the instability arising from the UK’s rejection of the EU was mostly limited to the UK itself. Still, this event put political risk back on investors’ radar. This was obvious enough in the bouts of risk aversion witnessed during the US election and the Italian referendum.

Improving GDP growth and inflation prospects

The third defining phase of 2016 was a gradual rise in GDP growth and inflation expectations starting in the summer, as global economic data brightened. The improving growth outlook and the hopes (starting in August) that an OPEC agreement on reducing oil output would be reached (as it was, on 30 November) drove oil prices up to USD 55 by the end of 2016. In parallel, the monetary environment remained highly accommodative and the G20 finance ministers promised to expand public spending and cut taxes in a bid to stimulate growth. These factors nudged investors towards a scenario of global reflation, i.e. GDP growth and inflation rising to new equilibrium levels, higher than those seen in recent years.

Donald Trump’s election as president of the United States did not undermine these expectations. Although risk aversion reared its head in the days leading up to the election, the reaction to Trump’s victory was highly positive. Taking their cue from Trump’s fiscal stimulus plans, investors raised their GDP growth

and inflation outlook for the United States. Amidst this surge of optimism, the Fed raised the fed funds rate to 0.75% in mid-December – and no one batted an eyelash. In addition, for the first time, the Fed upped its interest-rate forecast for the next three years and for the long term. The minutes of its meeting show that half of the monetary policy committee’s members factored the prospect of expansionary fiscal policy into their projections.

This change in sentiment among investors and their renewed expectation of global economic expansion had a major impact on the price of financial assets: bond yields in developed countries rose sharply, although this did not penalise equity indexes. At the end of 2016, global indexes posted a full-year rise of 5.3%. Even the strength of the dollar – its trade-weighted exchange rate climbed by 9.6% from August to December – did not spark a flare-up in risk aversion.

Analysis and implications

As we expected, in 2016 the central banks remained fully engaged and governments confirmed their fiscal stimulus plans. The authorities' responsiveness and an improvement in economic activity led investors to adopt an expansionary economic scenario.

As 2017 gets under way, expectations are high among investors. But these expectations will have to translate into reality – in terms of economic data and prices – for this confidence to last. If, as we expect, the upturn in yields and the strong dollar weigh on H1 GDP growth in the USA, some periods of uncertainty could arise.

Upcoming elections, in Europe in particular, could also trigger bouts of volatility, since investors are more attuned to political risk than before.

With optimism running high – and uncertainty still widespread – the central banks will have to keep their monetary policy very loose. We still expect the Fed to raise the fed funds rate only twice in 2017 – despite its own forecast of three increases – and the ECB to remain committed to its asset purchase programme throughout 2017.

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